Forecasting the term structure of variance swaps

Kai Detlefsen and Wolfgang Härdle

No 2006-052, SFB 649 Discussion Papers from Humboldt University Berlin, Collaborative Research Center 649: Economic Risk

Abstract: Recently, Diebold and Li (2003) obtained good forecasting results for yield curves in a reparametrized Nelson-Siegel framework. We analyze similar modeling approaches for price curves of variance swaps that serve nowadays as hedging instruments for options on realized variance. We consider the popular Heston model, reparametrize its variance swap price formula and model the entire variance swap curves by two exponential factors whose loadings evolve dynamically on a weekly basis. Generalizing this approach we consider a reparametrization of the three-dimensional Nelson-Siegel factor model. We show that these factors can be interpreted as level, slope and curvature and how they can be estimated directly from characteristic points of the curves. Moreover, we analyze a semiparametric factor model. Estimating autoregressive models for the factor loadings we get termstructure forecasts that we compare in addition to the random walk and the static Heston model that is often used in industry. In contrast to the results of Diebold and Li (2003) on yield curves, no model produces better forecasts of variance swap curves than the random walk but forecasting the Heston model improves the popular static Heston model. Moreover, the Heston model is better than the flexible semiparametric approach that outperforms the Nelson-Siegel model.

Keywords: Term structure; Variance swap curve; Heston model; Nelson- Siegel curve; Semiparametric factor model (search for similar items in EconPapers)
JEL-codes: C5 D4 G1 (search for similar items in EconPapers)
Date: 2006
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